Coal: In Search of Lower Cost Export Routes to China

The primary competition to coal is natural gas, which emits roughly half the carbon per unit of energy that coal does. The shift to burning gas instead of coal was swift as the term "coal substitution" became a new corporate buzzword associated with all things sustainable and environmentally friendly.

Public opinion in the U.S. is a harsh critic of the coal industry, but coal is cheap and is available in locations across the globe that may not be able to access or afford natural gas. It is the demand for coal as an export that may be able to help companies shipping coal from the U.S. to China compete -- the issue is transportation costs.

About an hour south of Gillette, WY, is NARM, or Peabody Energy Corp's (NYSE: BTU) North Antelope Rochelle Mine. The U.S. has the largest reserve of coal; the Powder River Basin has the largest reserve of coal in the U.S., and NARM is the largest mine in the Powder River Basin.

Peabody is enjoying a surge of business in places like India and China -- wherever populations are growing fast -- however sales are down $1 billion from 2012. Even with growing air quality issues, China continues to demand coal, especially in the Northern provinces. Greg Boyce, Peabody's chairman and CEO says the company's biggest challenge is finding export routes from the Powder River Basin to the Pacific Northwest -- shipping it through the Panama Canal is unprofitable.

When Boyce took over as CEO of Peabody in 2006 the world was in the middle of a commodities boom and Peabody was a cash-printing machine. Energy consumption was pushing new highs. The same year Boyce took over he also brokered a $1.5 billion acquisition of Excel Coal, a large producer of metallurgical coal in Australia. A few years later, in 2011, he purchased Macarthur Coal, an independent mining business in Australia for $5 billion. Both purchases placed Peabody closer to China and positioned the company to be a key player in the global coal trade, but the issue is getting the coal from the U.S. to China.

There's a school of thought that believes natural gas prices will drive an increase in the use of coal in the U.S. "The currently high price of natural gas is likely to steer utility companies away from natural gas and toward coal," argued the author of a recent Fool.com article. Meanwhile, the U.S. Energy Information Administration believes that total coal consumption will decline by 3.1% in 2015, as "retirements of coal power plants rise in response to the implementation of the Mercury and Air Toxics Standards."

Peabody isn't alone in the struggle. Alpha Natural Resources, (NYSE: ANR) was recently downgraded by Goldman Sachs from 'Cautious' to 'Sell' as the price target was slashed from $6 to $4 -- the primary reason for the downgrade being oversupply due to higher output in Australia.

Indeed, CONSOL Energy (NYSE: CNX) appears to be one of the only coal producers with real revenue growth as earnings beat consensus estimates by 2,800%, but this is mostly because CONSOL is transforming itself into a natural gas producer. In January the company announced that it would be investing approximately $1.5 billion in 2014 for the acceleration of natural gas production, committing to a 30% growth target. The CEO at the time had this to say:

We executed in 2013 by selling low-growth, non-core coal assets. Our primary sale, which closed last month, yielded approximately one billion dollars in cash when taking into account after-tax proceeds and related administrative cost reductions. We will apply these funds toward our aggressive 2014 natural gas drilling program. And once the BMX longwall starts late in the first quarter, we expect our coal business to also generate meaningful cash to support the capital program for the E&P segment of our company.

Feels like a bit of a conundrum: On one hand, CONSOL earnings are beyond expectations and natural gas prices are at near-term highs;on the other, analysts are calling out oversupply and downgrading the industry. The answer to the riddle is export shipping costs. Coal exports are going up because of the environmental restrictions placed on U.S. mining companies and abundant natural gas, but it's the company that can provide exports at the lower cost that can take advantage of the growing demand abroad.

"Exports are growing more essential by the moment, particularly for central Appalachian operations," remarked Ted Pile, a spokesman for Alpha Natural Resources, in a recent interview with The Wall Street Journal.

Much of CONSOL's success can be attributed to exports. Other coal companies pay fees to CONSOL to use its Baltimore terminal; it's the only terminal that's wholly owned by a coal/natural gas company. Bob Hodge, a coal analyst at IHS Energy says the terminal is CONSOL's "magic bullet." All other terminals along the East Coast are jointly owned, and three west coast coal terminals have been proposed for Oregon and Washington but are delayed due to environmental concerns.

"We make purchasing decisions based on price and quality, regardless of where it comes from," says Bill Steers, according to the article. Steers works for ArcelorMittal's mill in Tubaruo, Brazil. The company regularly buys coal from CONSOL even though it owns mines in the U.S. -- CONSOL owns the terminal and can provide better shipping rates.

Takeaway

The combination of higher natural gas prices and increased demand overseas may have temporarily offset the negative sentiment surrounding coal. This means investors need to look for earnings growth from coal companies that are transitioning to the natural gas market and/or are benefiting from greater export activity like CONSOL, which has a 1-year price return of 22%. Meanwhile, companies without a clear strategy for increasing export activity and mitigating shipping costs may find their shares losing value like Peabody and Alpha Natural Resources. Peabody had a 1-year price return of -47% and Alpha Natural Resources has a 1-yr price return of -23%.

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